Today marks the sixth anniversary since the Brexit vote, which triggered a significant surge in uncertainty that has been weighing on the economic activity. UK switched from being the best-performing economy in 2014 among the G7 to one of the weakest-performing economies in recent years. The UK is expected to be the worst-performing economy next year among G20 (after Russia) following the recent significant downward revision by the OECD, from 2.1% to 0%.
Hence, the stagflationary environment should continue to weigh on the British pound, which remains ‘cheap’ but very risky. In addition, the risk off sentiment driven by the geopolitical uncertainty and the sharp tightening in financial conditions (surging ST rates) leave equities vulnerable in the near term, which could also impact Sterling quite significantly.
Historically, the pound has been the most sensitive currency to high-volatility regime; periods of sharp drawdowns in equity markets are generally associated with aggressive pound selloff. For instance, Cable plunged from 1.32 to a low of 1.1412 during the March 2020 market panic.
The chart below shows the strong co-movement between GBPUSD and EM equities in the past 6 years (since Brexit), and therefore further retracement in equities (amid lack of visibility and convictions) leaves Sterling vulnerable in the near term.
Figure 1: GBPUSD vs. EM Equities(source: Bloomberg)
Implied volatility on the Japanese yen has been surging in recent weeks following BoJ dovish comments last month. Not only the BoJ has not expressed any interest in normalizing its policy despite the surge in inflation globally, the central bank recently offered to buy an unlimited amount of 10Y JGBs at 0.25% to limit the upside retracement in LT bond yields. As a result, the strong divergence in monetary policy between BoJ and other DM central banks (particularly the Fed) has led to a significant rise in USDJPY.
USDJPY broke above its 125.80 resistance (the high reached in 2015) to reach a high at 129.37 on Tuesday, and is now the worst performing currency among the DM world, down over 10% against the greenback since the start of the year.
JPY is now the most undervalued currency among the G10 world, currently trading 21.3% below its ‘fundamental’ value, which is estimated based on a BEER FX model using the terms of trade, interest rate and inflation differentials as explanatory variables.
Even though the yen appears as a ‘cheap’ currency to buy at the moment, MP divergence could continue to weigh on JPY in the near term. In the past cycle, the last two bullish trends on USDJPY driven by strong MP divergence saw an upward retracement of 20 to 25 figures. Hence, USDJPY could increase to at least 135 (start of the trend at 115), which represents a strong resistance (135 was the high reached in February 2002).
In the past year, we have seen that commodity prices have been constantly reaching new highs despite the significant slowdown in global growth. Part of the slowdown has been coming from the sharp deceleration in Chinese economic activity amid the ‘zero-Covid’ policy that has been strongly weighing on growth expectations. As a result, China ‘fundamental’ indicators, which have historically strongly co-moved with commodity prices, have been significantly diverging from commodity indexes since early 2021 (China indicators show that the economy peaked in February 2021).
For instance, this chart shows that while market uncertainty has kept China 10Y yield close to historical lows, copper prices keep reaching new highs (China represents 50% of the demand for copper).
Two major reasons explaining that divergence are:
Global supply chain disruptions (Covid disruptions, ‘natural disaster’ disruption i.e. South American droughts, and more recently the Ukraine war ‘shock).
Investment narrative, with investors seeking for ‘inflation hedges’ with inflationary pressures soaring globally. Historically, commodities have been the best ‘inflation-hedge’ (particularly oil and nat gas).
Figure 2. China 10Y yield vs. copper prices
The question now is: can the divergence persist if inflation is peaking and is now expected to slowly but gradually decelerate?
Long-term bond yields have been constantly testing new highs globally in the past two years (after finding a low following the Covid-19 shock) as inflationary pressures have been surging, particularly in recent months. While EM central banks (particularly Latam/CEEMEA ex-Turkey) have been hiking aggressively in the past year to tame inflation and limit the downside risk on the local currency, DM central banks have kept interest rates low in order to keep financial conditions as loose as possible to stimulate the economic recovery.
As the Ukraine war combined with the global supply chain disruptions (amid China renewed lockdown policies) will add on to the already existing inflationary pressures, DM central banks are likely to accelerate the tightening process this year, increasing the recession risk (particularly in Europe). The expected aggressive tightening by DM central banks is likely to lead to new highs in LT yields, questioning investors on how far LT bond yields can rise without ‘breaking’ the market.
Figure 1 represents the history of interest rates since the beginning of the 12th century up to today. The data source comes from Homer and Sylla’s book A History of Interest Rates (2005), which reviews interest rate trends in the major economies over four millennia of economic history. For the last 150 years, we compute a GDP-weighted average interest rate times series using a sample of 17 countries (Global LT interest Rate), using data from Jorda et al. paper The Rate of Return on Everything (2017).
Our global measure of LT bond yields is already up 112bps this year to 2.12%, and the historical average of LT bond yields stand between 4 and 5 percent (looking at hundreds of years of data). Will LT interest rates retrace towards their historical mean, or will the ‘deflationary forces’ win again?
With the Fed ending its POMO operations yesterday (March 9th) following a nearly 5tr USD increase in assets since the beginning of Covid, investors have remained skeptical if the equity market will be able to reach new highs in the medium term. The deterioration in the Russia/Ukraine conflict has left risky assets vulnerable since the start of the year, and the surge in inflation combined with a expected significant deceleration in the economic activity have increased investors’ cautiousness for 2022.
The chart below shows the strong relationship between SP500 and the Fed assets since the beginning of Covid. With the Fed balance sheet pausing at 9tr USD, could we see new all-time highs in US equities in 2022?
In addition to the consumer sentiment indicators, which have remained at ‘depressed levels’ amid Covid uncertainty in 2021 and the surge in inflation, the market uncertainty coming from the Russia/Ukraine conflict has increased the odds of a recession in 2022, particularly in Europe.
As war in Ukraine will lead to another inflationary shock, central banks will be ‘forced’ to tighten aggressively to tame inflation, which is approaching 10% in many EM and DM economies. As a result, the aggressive tightening response from central banks is very likely to accelerate the economic slowdown in the coming months.
Periods of surging ST rates have historically been followed by a significant deceleration in the economic activity. The chart below shows that the 2-year change in the 2-year US yield has strongly led the business cycle by 2 years in the past four decades. In the EM world, the impact is even faster with sharp increase in ST rates leading to economic slowdown in the next 6 months.
As opposed to the previous recessions in the past 30 years, governments and central banks will have limited ‘power’ this time as further stimulus and aggressive liquidity injections will lead to even higher inflation going forward.
Are we going to finally experience the ‘big bear’ equity market that a lot of participants have been waiting for in the past cycle?
The chart below (which has been circulating around in recent weeks/months) shows the dynamics of President Biden’s approval rating vs. US CPI inflation in the past year. Even though there have been multiple factors driving the popularity of US Presidents over time, we can agree that the surge in inflation has been one of the major factors behind the sharp fall in Biden’s approval rating in the past twelve months (from 54% in February 2021 to 43% in latest polls).
It is an interesting chart, though it is incomplete. US inflation will remain one of the major themes in markets for 2022 as inflationary pressures are likely to stay elevated longer than what policymakers previously anticipated. Therefore, the Fed will come under tremendous political pressure this year to tighten aggressively to ‘accelerate’ the convergence of inflation back towards its target.
Will Biden’s popularity surge back above the 50% threshold if inflation falls as the Fed tightens?
US politicians must not forget the ‘wealth effect’ factor and the importance of the dynamics of equities in the medium term. An aggressive tightening is likely to weigh on risky assets in the coming year after experiencing a tremendous rally in the past two years following the Covid19 shock. Hence, the impact of inflation Biden’s approval needs to be conditioned on equity market’s performance.
Isit better to have a 7%+ inflation and trending markets or 3% inflation and equities down 25%?
Since it reached its peak in August 2020, gold prices have been constantly reaching lower highs and are down over 12% despite the rise in inflationary pressures. Investors seem to have lost interest in the precious metal, which has not been very sensitive to the dynamics of inflation in the past year.
On the other hand, Bitcoin has experienced a strong co-movement with the US 5Y breakeven; the rise in inflation expectations in the past two months has been associated with a strong rally in Bitcoin prices, from $40,000 to over $60,000.
The chart below shows that Bitcoin has been a better ‘inflation-hedge’ than gold in the past year, and therefore new highs in US breakevens could support the cryptocurrency in the near term.
One strong particularity of gold though is that it has historically performed well in periods of rising political uncertainty and price volatility (which has not been the case for Bitcoin). For instance, while gold was up 3.6% in the first quarter of 2020 when US equities plummeted by 20%, bitcoin experienced a 9% drawdown.
In the past few months, the strong deceleration in the Chinese economic activity combined with the sharp contraction in ‘liquidity’ (Total Social Financing 12M Sum YoY change) have been weighing on the Aussie against major crosses. After peaking at 0.80 in February against the USD, the Aussie has been constantly testing new lows and is now down nearly 10% against the greenback.
AUD is now the most undervalued (-15%) currency among the G10 world according to our BEER model, which uses terms of trade, inflation and 10Y interest rate differentials as explanatory variables to compute the ‘fair’ value of currencies.
The second most undervalued currency is ‘risk-on’ GBP, standing at -13.2% from its ‘fair’ value. The rise in volatility combined with the deceleration in global liquidity have been weighing on Sterling in recent months.
On the other hand, the CHF is the most overvalued currencies against the USD (+7.7%) according to our BEER model, followed by the EUR (+3.8%). It is interesting to see that the Euro, which appears significantly undervalued from a PPP approach (PPP estimates the ‘fair’ value of EURUSD at 1.41 – implying that the EUR is over 18% undervalued), is now overvalued using a BEER approach.
In the past few months, we have seen that despite the significant decrease in economic surprise indexes, US equities have constantly been reaching new all-time highs, with the SP500 index breaking above the 4,500 level this week. We previously saw that the US mega-cap growth stocks (i.e. FANGs) have been mainly driven by the dramatic surge in global liquidity, which we compute as the total assets of the major G10 central banks.
As the FANGs stocks represent a significant share of the SP500 index (over 25%), the strong momentum in tech stocks have pushed the whole index to new highs.
Interestingly, the chart below also shows the strong relationship between the Fed’s balance sheet assets and the SP500 in the past year. As a reminder, when the Fed halted its POMO operations in the end of October 2014 (following nearly a year of tapering), US equities remained flat for 18 months and experienced several drawdowns before starting to edge higher in H2 2016 with markets starting to price in further stimulus (Tax reform plan, higher spending). See the article entitled ‘Could we survive without QE?’ that we wrote in September 2014 for more details.
Even though this time is different, there is still a lot of uncertainty over the economic recovery, therefore normalizing policy too early could halt the momentum in US equities in 2022. This is a challenging time for US policymakers as inflationary pressures remain elevated in both DM and EM economies and the Fed needs to normalize its policy in order to leave more room for a potential new economic shock in the future.